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Fairness Perceptions and Reservation Wages: The Behavioral Effects of Minimum Wage
Laws
Author(s): Armin Falk, Ernst Fehr and Christian Zehnder
Source: The Quarterly Journal of Economics, Vol. 121, No. 4 (Nov., 2006), pp. 1347-1381
Published by: Oxford University Press
Stable URL: https://www.jstor.org/stable/25098829
Accessed: 25-04-2020 22:53 UTC
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FAIRNESS PERCEPTIONS AND RESERVATION WAGES?
THE BEHAVIORAL EFFECTS OF MINIMUM
WAGE LAWS*
Armin Falk
Ernst Fehr
Christian Zehnder1″
In a laboratory experiment we show that minimum wages have significant
and lasting effects on subjects’ reservation wages. The temporary introduction of
a minimum wage leads to a rise in subjects’ reservation wages which persists even
after the minimum wage has been removed. Firms are therefore forced to pay
higher wages after the removal of the minimum wage than before its introduction.
As a consequence, the employment effects of removing the minimum wage are
significantly smaller than are the effects of its introduction. The impact of mini
mum wages on reservation wages may also explain the anomalously low utiliza
tion of subminimum wages if employers are given the opportunity to pay less than
a minimum wage previously introduced. It may further explain why employers
often increase workers’ wages after an increase in the minimum wage by an
amount exceeding that necessary for compliance with the higher minimum. At a
more general level, our results suggest that economic policy may affect people’s
behavior by shaping the perception of what is a fair transaction and by creating
entitlement effects.
I. Introduction
For decades, economists have been interested in the eco
nomic and social consequences of minimum wage laws. Important
puzzles remain, however, despite much progress in both labor
market theory and empirical analysis. First, several studies re
port anomalously low utilization of subminimum wages in situa
tions where employers could actually pay workers less than the
minimum [Freeman, Wayne, and Ichniowski 1981; Katz and
Krueger 1991, 1992; Manning and Dickens 2002]. Katz and
Krueger [1992] found, for example, that the introduction of the
opportunity to pay subminimum wages to youth had no discern
ible effect on teenage workers’ wages. This underutilization of the
*We gratefully acknowledge support from the Swiss National Science Foun
dation (101312-103898/1) and the Research Priority Program on the “Foundations
of Human Social Behavior?Altruism versus Egoism” at the University of Zurich.
We also would like to thank Lawrence Katz, Alan Krueger, Rafael Lalive, Alan
Manning, Andrew Oswald, and Marie Claire Villeval for helpful comments on
earlier drafts of this paper.
tArmin Falk: IZA and University of Bonn, falk@iza.org; Ernst Fehr and
Christian Zehnder: Institute for Empirical Research in Economics, efehr@
iew.unizh.ch, zehnder@iew.unizh.ch.
? 2006 by the President and Fellows of Harvard College and the Massachusetts Institute of
Technology.
The Quarterly Journal of Economics, November 2006
1347
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1348 QUARTERLY JOURNAL OF ECONOMICS
opportunity to pay less than the prevailing minimum occurred,
even though the vast majority of firms paid a starting wage below
the new hourly minimum immediately before it became effective.
Second, there is evidence that minimum wage laws have so-called
spillover effects [Card and Krueger 1995; Katz and Krueger 1992;
Dolado, Felgueroso, and Jimeno 1997; Teulings 2003; Teulings,
van Dieten, and Vogels 1998].1 For example, Katz and Krueger
[1992] and Card and Krueger [1995] show that after an increase
in the minimum wage, fast food restaurants increased wages for
workers by an amount in excess of that necessary for compliance
with the higher minimum wage. Third, the new minimum wage
research in the 1990s questioned the conventional wisdom that
increases in the legal minimum wage always cause a decrease in
employment, in particular, if the minimum wage increase is
modest [Card 1992; Card and Krueger 1994; Katz and Krueger
1992; Machin and Manning 1994; Dolado et al. 1996]. Although
these results remain contested, it is probably fair to say that they
represent a considerable challenge to the conventional view ofthe
employment effects of minimum wages (see, e.g., Neumark and
Wascher [1992, 2000], Card, Katz, and Krueger [1994], and Card
and Krueger [2000]).
Why do profit-maximizing employers not take advantage of
the possibility of reducing wages below the legal minimum, and
why do they pay more than the required minimum for those
workers who earned less than the new minimum wage before it
was introduced? We report the results of laboratory experiments
that examine possible driving forces behind these phenomena in
this paper. We provide, in particular, evidence showing why
profit-maximizing employers may find it profitable to pay workers
much higher wages after the removal of a legal minimum wage
than before its introduction.2 This result provides a possible
explanation for the anomalously low utilization of subminimum
wage opportunities because these opportunities were typically
introduced after a previous increase in the minimum wage. In
addition, our data show why profit-maximizing employers may
find it optimal to pay wages above the minimum wage even if they
paid wages much lower than the minimum wage before its intro
1. A notable exception is the United Kingdom where no spillover effects have
been found [Manning and Dickens 2002].
2. Throughout the paper we use the term “employer” or “firm” for subjects
who are in the role of an employer in the laboratory experiment. The term
“worker” is used for subjects who are in the role of a worker in the experiment.
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FAIRNESS PERCEPTIONS AND RESERVATION WAGES 1349
duction. This result provides an explanation for the second puz
zle, i.e., why there are wage spillover effects. Finally, we report
evidence suggesting that employers may find it optimal neither to
decrease employment after the introduction of a binding mini
mum wage nor to increase employment after its removal.
We identify the observed pattern of reservation wages as the
driving force behind all these phenomena. Workers’ fairness con
cerns shape individual reservation wages in our experiment and
give rise to upward sloping labor supply schedules at the firm
level. We observe that the minimum wage strongly affects reser
vation wages, suggesting that it influences what is perceived as a
fair wage. After the introduction of a minimum wage, workers’
reservation wages increase, and a substantial share of the work
ers even exhibits reservation wages above the legal minimum.
Profit-maximizing firms are thus forced to pay wages above the
minimum, which explains the spillover effect.3 After the removal
of the minimum wage, workers’ reservation wages decrease some
what; however, they still substantially exceed those before the
introduction of the minimum wage. It seems that the minimum
wage leads to a kind of ratchet effect in workers’ perception of
what constitutes a fair wage. This means that individual firms
face a tighter labor supply schedule after the removal of the
minimum wage than before its introduction. Therefore, the pay
ment of substantially higher wages after the removal of the
minimum wage than before the introduction is a profit-maximiz
ing strategy. This finding explains why firms may find it unprof
itable to utilize subminimum wage opportunities and echoes re
sults reported in Katz and Krueger [1992]. They report that 62
percent of fast food restaurant managers not using the submini
mum opportunity for youth believed they could not “attract quali
fied teenage workers at the subminimum wage” although the vast
majority of these restaurants hired workers at less than the new
minimum wage prior to its increase.4
3. Flinn [2005] shows that minimum wages can also affect workers’ reserva
tion wages in search and matching models with wage bargaining. The reason is
that the minimum wage changes the asset values of unemployment and employ
ment. However, as firms and workers are exogenously rematched in every period
of our experiment, these effects cannot play a role in our setup. Teulings [2005]
provides an elegant explanation of spillover effects in an extended competitive
model. Teuling’s explanation and our explanation in terms of changes in reserva
tion wages are not mutually incompatible.
4. The fact that reservation wages and, hence, actual wages remain high
after the removal of the minimum wage may also inform us about the forces
behind the adjustment of reservation wages over time. Our result suggests that
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1350 QUARTERLY JOURNAL OF ECONOMICS
The pattern of reservation wages also shapes the employ
ment effect of the minimum wage. Since workers’ fairness con
cerns impose an upward sloping labor supply constraint on indi
vidual firms, firms can increase employment if they pay higher
wages. Theoretical analyses [Rebitzer and Taylor 1991; Manning
1995, 2003; Burdett and Mortensen 1998; Bhaskar and To 1999]
indicate that a minimum wage may actually increase employ
ment under these circumstances. This is, however, not obvious in
our context. As the minimum wage not only increases wages but
also reservation wages, firms may also reduce employment. We
find that the increase in reservation wages is not strong enough
such that the introduction of a binding minimum wage has a
positive net effect on employment. In addition, the asymmetric
response of reservation wages to the introduction and the re
moval of the minimum wage is associated with asymmetric em
ployment effects: employment decreases less after the removal of
the minimum wage than it increased after the introduction of the
minimum wage.5
To what extent should one expect the behavioral forces iden
tified in the experiment to be present in labor markets outside the
laboratory as well? Although it is advisable to be cautious when
generalizing findings from one empirical domain to another, we
believe that the impact of minimum wages on reservation wages
might well be present in labor markets outside the laboratory.
First, fairness concerns, which shape reservation wages in our
experiment, have been shown to affect laboratory behaviors even
at rather high stake levels?up to three months’ income [Cam
eron 1999; Slonim and Roth 1998; Fehr, Fischbacher, and Tou
gareva 2002]. Thus, the argument that stakes are higher in the
“field” than in the laboratory and that the laboratory results can
therefore be dismissed as irrelevant, is on weak ground. Second,
the argument that we used a rather narrow subject pool?stu
dents?in our experiment is also not compelling because evidence
actual wage payments which were previously experienced may strongly shape
reservation wages. This finding may have important consequences for the debate
regarding the compatibility of the “wage curve,” as documented by Blanchflower
and Oswald [1994], and the Phillips curve. In particular, one condition for the
compatibility of the wage curve approach with the Phillips curve approach is that
past increases in real wages be fully reflected in current increases in reservation
wages [Blanchard and Katz 1997, 1999].
5. Similar to our findings Kramarz and Philippon [2001] report for the
French labor market between 1990 and 1998 that the effects of labor cost in
creases and decreases caused by legal changes were not symmetric.
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FAIRNESS PERCEPTIONS AND RESERVATION WAGES 1351
from representative experiments from Germany, the Nether
lands, and Switzerland show that the basic behavioral patterns
observed in fairness-related experiments with students also pre
vail in representative samples [Bellemare and Kroger 2004; Fehr
et al. 2002; Falk and Zehnder 2006]. Third, evidence from ques
tionnaire studies with firms’ human resource managers?some of
them even with representative samples of firms?suggests that
workers’ fairness concerns play a prominent role in firm’s wage
policies [Bewley 1999; Agell and Bennmarker 2003]. Finally, re
cent papers indicate that laboratory measures of social prefer
ences can be good predictors of behavior in field settings. Karlan
[2005] shows that reciprocity (i.e., trustworthiness) in trust
games predicts subjects’ loan repayments one year after a labo
ratory experiment, and Carpenter and Seki’s work [2005] sug
gests that laboratory measures of conditional cooperation forecast
productivity in the workplace.
At a more general level, our results indicate that economic
policies may not only affect private agents’ incentives, but also
change their perception of what is fair and create entitlement or
status quo effects. In the past, economists have concentrated
their efforts on understanding the incentive effects of government
policies. However, our results?in combination with other recent
evidence [Madrian and Shea 2001; Ariely, Loewenstein, and
Prelec 2003] demonstrating that seemingly innocuous situational
details can have powerful behavioral effects?suggest that econo
mists may gain substantially by also focusing their research on
these other effects of government policies. The work by Ariely,
Loewenstein, and Prelec [2003], for example, shows that arbi
trary anchors have strong effects on subjects’ reservation prices.
If arbitrary anchors are even able to affect reservation values,
should we not also expect a government intervention as strong
and as salient as an increase in minimum wages to influence
reservation wages strongly? Thus, public policies are likely to
affect behavior not only through changing incentives but also by
shaping perceptions of entitlements and, thus, reservation
values.
In the following, we first present our experimental design.
Then we show our results in Section III. In Section IV we examine
the extent to which the impact of minimum wages is due to the
fact that minimum wages are necessarily a kind of wage guide
line; we thus study the impact of nonbinding wage guidelines on
actual wages and reservation wages in this section. Section V
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1352 QUARTERLY JOURNAL OF ECONOMICS
TABLE I
Firms’ Revenue Function
Employed workers Total revenue Marginal revenue
0
0
1
2
3
39
74
10
discuss
side
the
might
impact
II.
Ex
In
this
describ
treatm
predictions.
II.A. The Experimental Game
Workers are randomly matched to firms in each period ofthe
experiment, and can only conclude a contract with the firm with
which they are matched. There are six firms and eighteen work
ers in each experimental session; i.e., each of the six firms is
randomly matched with three workers in each period. Firms have
identical revenue functions with labor as the only variable input
and a decreasing marginal revenue product of labor. To hire
workers, firms can submit a unitary wage offer w to the matched
workers; i.e., wage discrimination is ruled out. Firms can make
wage offers to all matched workers or to fewer workers. Workers
do not know how many wage offers the firm makes; each individ
ual worker only knows whether he or she received a wage offer.
A worker can accept or reject w. If the worker rejects w, he or
she is unemployed and earns nothing in this period. If a worker
accepts the offer, a binding contract is concluded; the worker
receives w, and the firms’ revenue increases according to the
marginal revenue the worker generates. Each firm’s revenue
function is shown in Table I. Firms’ profits are given by total
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FAIRNESS PERCEPTIONS AND RESERVATION WAGES 1353
revenue minus wages. Thus, an individual firm’s profit function is
as follows:
0, if no worker is employed
tt _. 390 – u;, if one worker is employed
Firm – 740 – 2w, if two workers are employed
1000 – 3w, if three workers are employed.
Workers’ payoffs depend on the wage offer and on whether the
offer is accepted or rejected. Thus, payoffs for workers are
10, if no wage offer is received
0, if a wage offer is rejected
w, if a wage offers is accepted.
Both workers’ and firms’ payoff functions are common knowledge
among the participants. After all decisions in a period are made,
payoffs are calculated and displayed on the subjects’ computer
screens: firms are informed both about their own payoffs and
those of the workers with whom they have been matched; work
ers, too, are informed both about their own payoffs and that of
their firm. The next period begins after all subjects have received
this payoff information.
Since we were particularly interested in workers’ individual
reservation wages, we used the strategy method to elicit workers’
acceptance decisions. To this end, workers were asked to indicate
the lowest wage they would in fact be willing to accept before they
knew which wage offer they actually received. If the wage offer
actually received was lower than the worker’s acceptance thresh
old, the offer was automatically rejected; otherwise it was ac
cepted. Note that the specification of an acceptance threshold
determined a worker’s complete strategy, because the worker
implicitly stated his accept/reject response to every possible wage
offer. Neither the firms nor the other workers were informed
about an individual workers’ acceptance threshold. A firm was
only informed about how many workers accepted its wage offer.
The acceptance threshold represents a worker’s reservation
wage. This information about reservation wages will prove useful
for understanding the firms’ behavioral responses to the intro
duction and the removal of minimum wages. In addition, the
information about reservation wages enables us to implement a
useful matching procedure. A large body of evidence now indi
cates that a significant share of experimental subjects exhibit a
preference for fairness and reciprocity [Camerer 2003; Fehr and
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1354 QUARTERLY JOURNAL OF ECONOMICS
Gachter 2000]. In addition, the strength of fairness motives dif
fers among those subjects who care for fairness. Therefore, we
expected both a significant share of the workers to exhibit posi
tive reservation wages as well as heterogeneity in these reserva
tion wages. This means that?on average?firms face an upward
sloping labor supply schedule. Thus, if we play the experiment for
a very large numb …
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